Panelists at Markets Group’s Sixth Annual Texas Institutional Forum in Austin, Texas, last week, delved deep into the topic of private debt as an asset class. They weighed in on the difficulties in benchmarking for the asset class, allocating to the asset class and everything in between.
Moderator Sylvia Owens, a senior portfolio advisor at Aksia, first tackled real estate private credit (PC), noting that it is a relatively attractive asset class, but that it has been a harder area for most general partners (GPs) to tap. “For example, when a GP meets with a public pension plan with various asset buckets, the team that is responsible for PC, e.g. the fixed income portfolio managers, may not consider real estate their area, while the real estate team is benchmarked against an equity index, so they’re not motivated to introduce tracking risk,” she said. Regarding trying to come up with a private credit benchmark that reflects current and future exposure, she said “it’s hard, there are so many different PC strategies to consider, and where does it stop? The trend which we are seeing, for that reason, is some investors opting for a more straightforward ‘opportunity cost’ based benchmark, rather than trying to keep up with adding or changing the benchmark mix of strategies over time.”
The strategies can get really granular, agreed Ruchit Shah, portfolio manager for alternative fixed income and private credit at the Texas Treasury Safekeeping Trust Company (the Trust Company), which oversees more than $50 billion in assets for the state of Texas. “It is a very hard asset class to benchmark because there’re so many different flavors of private credit, and there’re totally different risk profiles,” he added. “At the moment, our approach is to use a Cambridge & Associates benchmark that is more focused on a mezzanine benchmark. Some folks put global credit in global fixed income—if you do that and benchmark yourself to the Barclay’s Aggregate, middle market direct lending looks awesome on an unlevered basis,” Shah continued. “One of the reasons you’re seeing so much capital flow into middle-market direct lending is because people are thinking about it as a yield pickup, compared to just long-only global fixed income.”
Defining private credit
Defining private credit is key, because it can be seen as synonymous with direct lending. But there is, in fact, a lot more to private credit, Owens said. “At Aksia, we have a broad view of private credit, across seven sectors and 76+ sub-strategies. Really any credit or yield generating strategy that is in a PE drawdown structure is how we draw the line—this can also include some open ended vehicles, but these are exceptions,” she said.
The Trust Company has a broad definition of private credit, which can include illiquid credit and distressed strategies, Shah noted.
The $154 billion Teacher Retirement System of Texas (TRS) pension fund, meanwhile, considers private credit investing in credit instruments that quite simply are not actively traded, with the exception being structured credit where there may be some amount of secondary market trading activity, noted Jesse Hibbard, Investment Manager in the Special Opportunities Group at TRS.
“In private credit, the general partner (GP) usually originates the product that you’re investing in,” added Hibbard. “We tend to bucketize private or illiquid credit into three silos—first, direct lending, where the GP is originating the senior, 2nd lien or mez instrument; second, specialty lending which is in most scenarios similar to direct lending though there is usually a domain expertise angle to it; and the third bucket is structured credit which includes reg cap and CLOs and involves combining credit analysis with a statistically driven investment strategy,” he noted.
Why is private credit attractive now?
Within investor portfolios, not only are many private credit allocations designed to enhance overall yield, the other motivation, particularly for a more opportunistic program, is to capture return streams based on other collateral types, which can be diversifying to the rest of the plan and historically may have fallen through the cracks, Owens said.
The Trust Company values the exposure private credit provides to niche strategies that are not available in liquid markets, Shah said. “Private credit enables you to get a total return from a niche strategy that is not going to be found as much in the public markets—that’s our primary motivation,” he added. “At this moment, we are not in private credit just to clip a coupon and get a yield pickup.”
We are not in private credit just to clip a coupon and get a yield pickup.
Private credit as a diversifier
In ArrowMark Partners’ conversations with investors, a secular view exists that private credit is a portfolio diversifier and not just a source of absolute returns, said Tim Beresford, client portfolio manager at the Denver-based firm with $19 billion in AUM. “For example, regulatory capital relief securities have displayed resilience during periods of market volatility over the last several years. The ability to potentially withstand market pressure comes from collateral quality and diversification as well as the alignment created with the issuing bank through the structure of the securities,” he added.
Still, caution abounds
TRS is cautious on the direct lending market for several reasons, however. “The market has been around for some time and there have been a number of new entrants into the space making it very competitive,” said Hibbard. This has allowed the frothiness of the large-cap leverage loan market, where three-page EBITDA definitions have creeped in and covenant lite deals are the norm, to make its way into many of the terms in direct lending space resulting in far inferior pricing and deal structures,” he added.
The Trust Company, in fact, has a special name for its strategy: a complexity premia. “Right now, investors sit at a point where an unlevered bank loan portfolio can earn between 5.5 and 6 percent—that’s pretty good, and a year or two ago it was unachievable,” Shah said. “What’s the alternative? One alternative is to be in liquid bank loans. I’m a private credit guy, but it is important to understand that the liquid markets are offering you something that is not as terrible as it once was,” he said. “We do have to think a little bit more aggressively, especially as illiquidity premiums are relatively tight. Investors must ask: ‘what is the value of illiquidity being assigned here?’ People want you to lockup for as long as they can get you to.”
Dispersion of return
Another issue that investors with dedicated private credit buckets are spending a lot of time thinking about is dispersion of return. “We’re seeing interest from investors regarding PC focused pacing studies–they are concerned that the large amount of capital being deployed in the strategy could leave them overallocated versus targets,” noted Owens. “In general, however, we believe that investors may underestimate how quickly capital will return from PC strategies, which can lead to the opposite issue of being under allocated versus stated targets. This problem is exacerbated when investors attempt to use private equity pacing models for PC investments, despite the tendency for PC to return capital more quickly.”
In 2017, only a very small percentage of PC fundraising was for GPs focused outside of the U.S.
Private credit outside of the US
There has also been interest in PC on the non-U.S. side, including Europe, Southeast Asia, China, Australia and India, noted Owens. Asia is still a very small part of the PC landscape, said Owens, citing Preqin data that, in 2017, only a very small percentage of PC fundraising was for GPs focused on this area. “A lot of investors are thinking about it for the longer term but there are many jurisdictional and regulatory issues so you need to be cautious” she continued. “That said, we are focused on identifying areas of the PC landscape where the capital supply/demand imbalance may benefit the investor, and in many parts of Asia, there is a need for debt financing to fund the growth of companies, but less private debt capital is available.
Investing in Indian NPLs was a very large opportunity set that TRS evaluated and ultimately passed on, for now, said Hibbard. “From TRS’ perspective, India has $150 billion in NPLs and recently instituted a new bankruptcy code, but we found that the gross returns available were more mid-teens, which we didn’t think sufficiently compensated us for the underlying risk of working out a fairly nascent legal regime,” he added.
The currency risk must be accounted for in India, Shah agreed. “India’s premium to European non-performing loans (NPLs) is not enough, but on the lending side, the premium to the U.S. middle market direct lending for similar corporate risk is pretty good,” he added. “Investors must ask themselves: are you getting paid for that India or China risk, building blocks-wise? The amount of private equity dry powder in Europe is around $5 versus $1 of private debt dry powder; in the U.S., it’s around $3 to $1, and in Asia, it is $14 to $. That may explain a bit why these premiums are there in that market,” he concluded.